B(l)ank cheques

Rating agency Moody’s today downgraded a swathe of UK banks. The reasoning behind this was not the weakening of the economy, nor the fact that, according to Mervyn King, we are in possibly the worst financial crisis ever. It was due to the changing nature of the blank cheque that banks receive from their implicit support from the state.

The rating agencies have recognised that government policy has shifted and that state support for banks is becoming limited and dependent on their systemic importance to the UK economy. This is not new news and the increasing risk that bank bond holders have been exposed to is something we have talked about before and has been illustrated painfully by recent price movements.

However, some interesting comments and pointers come out of the Moody’s press release. They not only assign higher ratings to some banks due to their size, but assign these higher ratings also due to their complexity ie “driven by large cross-border trading and derivative books”. This seems somewhat perverse for the state. Surely it does not want to be on the hook by providing more support to banks that threaten the domestic system due to cross border activities and complex derivative books, which the regulator has respectively less control over and less understanding of.

Going forward, the UK tripartite authorities (the Bank of England, the Financial Services Authority and the Treasury) are going to aim, through implementing policies along those recommended by the Independent Commission on Banking, to reduce this subsidy for too big to fail and too complex to fail banks. The eventual implementation of such policy would logically result in further downgrades of UK banks by the rating agencies.

The bank checks of the tripartite authorities mean fewer blank cheques. It appears under this scenario we still have further to go in the deteriorating credit quality of many UK banks as conferred upon them by the rating agencies.

The value of investments will fluctuate, which will cause prices to fall as well as rise and you may not get back the original amount you invested. Past performance is not a guide to future performance.

Richard Woolnough

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